Some See ‘Great Rotation’ Beginning

November 28, 2016

Turning Point

But as inflation expectations are overhauled, so are perceptions about the rate outlook—money markets are starting to price in one or more Federal Reserve rate hikes next year, a sea change from before the election, when they priced in a less than 50% chance of a 2017 Fed hike.

It's against this backdrop that early indicators of a rotation can be seen.

J.P. Morgan also noted that, over the past week, a record inflow into U.S. equity exchange-traded funds was accompanied by a record outflow from bond ETFs.

Within equity markets, a sharp rotation out of so-called bond proxiesdividend-paying sectors such as utilities, telecoms and health care, which are favored by investors for their yieldand into more cyclical sectors such as banks, industrials and commodities-related sectors, is already underway.

Dividend Fade May Be Precursor

The fading allure of dividends could be a precursor to a broader asset-class switch out of bonds and into stocks, which are more geared to economic growth and an inflation pickup.

This trend has taken hold across global equity markets. Basic resources and energy are now the best-performing equity sectors within the MSCI all-country World indexes, both up about a fifth this year. Health care, utilities, and food and beverage stocks are the biggest laggards, and the only three in the red for 2016.

"It's too early to tell, but this is the best chance I've seen in a long time," said Michael Antonelli, an institutional sales trader at R. W. Baird & Co., referring to a great rotation.

"Money chases performance, and it is thus and ever shall be, so we need equity funds to start knocking the cover off the ball," he added, alluding to an opportunity for equity funds to make strong gains.

What To Look For Ahead

One sign that a great rotation is taking hold is if investors continue to offload bonds on a large scale.

"We know in general that a lot of capital has gone into fixed income, so how investors react to this sell-off is really important," said Michael Metcalfe, head of macro strategy at State Street Global Markets. "If they capitulate, they will drive the next leg of it clearly."

Any rotation is likely to be driven by the United States, where bonds have seen some of the steepest selling in years. In Europe and Japan, still-subdued inflation and ultra-loose monetary policy are expected to provide some support to bonds.

Rising political risks in the euro area such as in Italy also suggest demand for safe-haven German bonds remains firm, with two-year yields hitting record lows on Friday at minus 0.75%.

Long-term investors such as pension funds, hurt by an era of negative bond yields, are also likely to welcome any sell-off to lock in yields at higher levels.

"Against that, you could have someone like a retail investor not wanting to own fixed income. So really the idea of a great rotation will depend on who that marginal buyer or seller of fixed income is," said Nick Gartside, chief investment officer for fixed income at J.P. Morgan Asset Management.

 

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